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The hidden costs of switching to a cheaper pension plan

Numerous employers, including Air Canada, have been taking steps to close their traditional defined-benefit employee pension plans.

Graham Hughes/The Canadian Press/Graham Hughes/The Canadian Press

Closing traditional pension plans to new hires is an increasingly popular way for employers to curb soaring funding obligations, but it's not a quick fix and can even lead to unexpected costs.

Air Canada and Canada Post both proposed the idea in high-profile labour disputes with employees last month, and numerous other employers are taking steps to close their traditional defined-benefit employee pension plans. Typically, new workers are then enrolled in defined-contribution plans, which do not pay a guaranteed level of retirement income, so employers are not required to fund shortfalls.

While funding problems mean the conversion trend from defined-benefit (DB) to defined-contribution (DC) is unlikely to slow, pension experts say companies should be aware it can take decades for funding costs to start to come down, and in the meantime they can face unexpected human-resources costs, such as the loss of a key employee-retention tool.

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"[The conversion strategy]doesn't do much for about 20 years," says Mercer pension consultant Paul Forestell, who has worked with companies closing their pension plans. "We've looked at it for clients where their liabilities don't even start to peak until 10 years out … It's like a snake – until you get that bulge through, you don't save any money."

That's because employees remaining in the traditional DB pension plan still carry high costs, particularly as they reach their peak earning years.

The Saskatchewan government was one of Canada's first employers to close its pension plans to new hires, starting in 1977, and switch new workers into DC plans, where pensions vary depending on investment returns.

Thirty-four years later, there are still 1,000 active employees in the old plans who haven't retired yet, said assistant deputy minister of finance Brian Smith. He estimates it will take well over 80 years until the last remaining members of the DB plans – which pay a guaranteed income in retirement – have died and the plans can be wrapped up.

"The issue of it lasting for 90 years to wind it up is an issue I'm not sure many employers think about. It's a long time."

Vancouver pension lawyer Ken Burns recently reviewed the experience of pension plans that converted to the DC model in the 1990s and found most of them are still not saving money. That's partly because the remaining DB plans have seen costs soar in the current low-interest-rate environment, and partly because they are incurring new costs to run their DC plans.

"If you close a DB pension plan now to new hires, you're still going to be running a DB plan 60 or 70 years from now," Mr. Burns says. "When these [conversions]were happening in the 1990s, running a DC plan looked really simple. Now it's more complicated," given current legal risks and education requirements.

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But financial considerations are pushing wind-ups, despite their drawbacks. Since the financial downturn in 2008, the trend has escalated as companies face growing pension plan deficits and crippling obligations to add cash to fund plan shortfalls.

Statistics Canada data show membership in DC plans climbed almost 8 per cent between 2006 and 2010, to 961,000 people, while the number of employees in DB plans fell by 1.6 per cent. And those who are members of both DB and DC plans – often due to plan conversions – climbed 880 per cent in the same period from just 40,000 people to 392,000 by 2010.

Towers Watson pension consultant Ian Markham said the logic from an employer's point of view is obvious: DB plans are more volatile and carry long-term funding obligations, but they also simply cost more on an annual basis. That's because employers typically contribute between 7 per cent and 9 per cent of employee salary costs to the plans, while the average contribution to DC plans is about 5 per cent of wages per employee.

Michelle Loder, who heads the DC consulting practice at Towers Watson in Canada, says the average contribution to DC plans is likely even lower, because employers typically match employee contributions to a maximum of 5 per cent, and employees typically do not contribute the maximum amount.

She added employees also typically bear most of the costs of managing the DC funds. Fees paid to financial institutions providing the investments are a built-in percentage of the value of the funds under management. Employers typically only pay a small additional flat fee per employee to cover other administrative expenses.

On the flip side, there are also higher costs that are not often considered when plans are converted.

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Many companies feel obliged to provide more information and education to workers in DC plans, for instance, because employees – who bear the risks themselves – must choose among investment options provided by an outside investment management firm.

There are other costs that are more difficult to quantify. It can be harder to retain mid-career workers who are more willing to switch jobs if they don't have a pension plan, for instance, and harder to get older employees to retire, especially when their DC pension plans have been devalued by a market downturn. Companies also lose the flexibility to offer incentives to encourage workers to retire early in downtimes.

"You're shifting the problems from a financial element to an [human resources] element," Mr. Markham said.

But he notes some of the risks could be mitigated with better DC plans that improve the odds employees will have larger pensions by their retirement age.

In Saskatchewan's civil service, employees are required to join the DC plan and make the maximum possible annual contribution – which averages 7 per cent among the different plans. That means a higher benefit in retirement, which is further bolstered by charging workers lower asset management fees.

Mr. Smith said the DC plan is now the largest in Canada with almost $5-billion in assets, which helps reduce administrative costs because the scale allows the government to negotiate a better deal with financial managers, with administration fees averaging just 0.39 per cent of fund assets.

"That's very cheap," Mr. Smith says. "If people think you can't run a DC plan cheaply, they're wrong."


Pension conversions

Canadian employers are increasingly shifting employees to defined-contribution pension plans -- which do not provide a guaranteed level of income and vary depending on investment returns -- over traditional defined-benefit plans, which guarantee a payment level in retirement.

Membership in defined benefit plans:

2006 -- 4,600,581

2007 -- 4,590,805

2008 -- 4,538,192

2009 -- 4,505,211

2010 -- 4,529,059

Change: -1.6%

Membership in defined contribution plans:

2006 -- 893,403

2007 -- 899,540

2008 -- 935,236

2009 -- 939,157

2010 -- 961,845

Change +7.7%

Membership in combined defined benefit and defined contribution plans:

2006 -- 40,057

2007 -- 79,760

2008 -- 201,895

2009 -- 395,053

2010 -- 392,076

Change +880%

Source: Statistics Canada

Pension coverage

Percentage of private-sector employees covered by a workplace registered pension plan in Canada:

1977: 35.2%

1987: 31.1%

1997: 28.2%

2007: 25.5%

Percentage of public-sector employees covered by a workplace registered pension plan in Canada:

1977: 75.5%

1987: 78.9%

1997: 88%

2007: 83.9%

Source: Statistics Canada

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Real Estate Reporter

Janet McFarland is the real estate reporter for The Globe and Mail’s Report on Business, with a focus on residential real estate trends. She joined Report on Business in 1995, and has specialized in reporting on corporate governance, executive compensation, pension policy, business law, securities regulation and enforcement of white-collar crime. More

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